Stock Market Valuation August 1st 2011

August 1, 2011 11:04 pmby

I started this monthly market valuation series in December 2009. The reason for it was I was getting tired of hearing that the market was overvalued because PE TTM was 87. This was ridiculous because earnings were deflated by the worst economic crash since the great depression. However, the question was how to value the market from a purely quantitative methodology, while ignoring all the outside noise and macro predictions of where the economy is headed. I looked for several different metrics to evaluate the market which over time have proven to be effective and decided to look at all the metrics, instead of just focusing on the last 12 months of earnings.

I was contemplating only updating the valuations on a quarterly basis, since why is there a need every month? However, since the market was and in general continues to be quite volatile, I consider it useful to evaluate on a monthly basis. When volatility truly gets to lower levels, it will suffice to update these series on a quarterly basis.

The current level of the S&P500 is 1287, and the Dow is at 12,123– slightly lower than last month. As evidenced below, market valuations did not change much over the last month.

In conclusion, the market is overvalued based on the above data. Tobins Q, Shiller PE and PB data are all indicating that investors are too bullish and valuations are too high.

However, the historical data fails to take into account current record low interest rates. I know not many investors take issue with my inclusion of interest rates in the equation. However, I think that investors should look at the stock/bond alternative. Right now you can get some blue chip stocks with dividend yields close to the Ten year treasury yield.

However, eventually the market will likely returns to normal valuation ratios as interest rates reach more normal levels. I believe returns over the next 10 years will be sub-par (far below the 9.5% average market return). I think we will likely see returns equal to inflation over the coming decade.

Note: I have received numerous suggestions on how to improve my monthly series. I tried to incorporate these ideas in my current article. Please leave a comment if you would like to provide further suggestions, I plan on significantly improving this article for next month.

Stay tuned till the beginning of next month for the next monthly valuation article.